European bank-stress-test results were announced last week. The good news: only 13 out of 130 banks didn’t make passing grades. The bad news: this test says nothing about how well or badly these banks may do as going concerns in times of stress.

According to the New York Times, “the European Central Bank said its analysis was intended to strengthen banks’ balance sheets, improve transparency in reporting and persuade investors that these institutions are sound.”

This intent would have some credibility if before 2008 regulators had pointed out the banks that were not sound and then if some of them failed during the crisis. But there were no such judgments implying that no one could tell before the crisis which banks were sound and which were unsound.

Bank failures generally come as a surprise in crises. This is because today’s assessment of the soundness of banks is based upon so many subjective assumptions that it fails to prepare banks for the surprises extreme crises bring. The weakest link in the way current stress testing is done is the assigning of values to assets. In relation to the survival of banks in crises, it is a meaningless exercise. This is because no one knows what value these assets will have during crises. What compounds this problem is that such values-in-crisis are assigned during normal times when it is hard to envision a crisis environment.

In a conversation a couple of years ago, a senior risk manager at a large financial institution said that no one had foreseen before 2008 that the value of some the mortgage-related assets would be down by 10-15%. Everyone thought, he said, that a 5% loss would be the maximum deterioration. Actual loss turned out to be more than 20%.

So today’s stress testing is designed with the last crisis in mind. Actual results may turn out to be not as bad as assumed in such testing in some areas considered critical, but some other surprise that no one had thought of may doom institutions.

For the first time in history, regulators are requiring financial institutions to have a specific amount of liquid assets on hand to withstand a 30-day run by creditors and depositors, should a sudden crisis strike again. This is a right step to keep the system from freezing as happened in 2008.

However, will focusing on liquidity prevent what can devastate institutions in crises as experienced by Bear Stearns, Lehman and Wachovia? No, it will not, because institutional liquidity problems in crises are caused by a more fundamental factor.

A series of catastrophic events in recent years have sensitized corporations, governments and other institutions to the low-probability, high-impact threats known in the risk management profession as tail risks. These events have been occurring with increasing frequency in the form of both natural and human-caused disasters. The financial kind is the focus of veteran risk manager and adviser Karamjeet Paul in the recently published Managing Extreme Financial Risk: Strategies and Tactics for Going Concerns. He notes that the crisis of 2008-’09 was but the latest — and certainly the most costly and far-reaching — of a modern progression that included the stock market crash of 1987, the savings and loan failures of the early 1990s, Long Term Capital Management and the Asian debt collapse in the late 1990s, and the Internet bubble shortly thereafter. Given this established, albeit unpredictable, pattern of mounting costs and concerns, Paul explains how conventional modeling is ill-suited for tail risks and lays out a framework for managing them that he defines as “sustainability management,” taking into account the systemic and operational consequences of extreme events that threaten not only a firm’s profitability, but also its very existence. (Click here to read more …)